Active versus Passive Investing

Maximizing investment returns in a safe manner requires balancing a number of tradeoffs. First, what you earn through your investments versus the transaction costs and taxes you have to pay. All else held equal, you want the highest net returns. Second, the balance between the amount of risk you take and expected return — as I talked about in my recent post on balancing safe but boring investments with risky but exciting ones, you want the core of your portfolio to be boring but safe. A key variable for managing those tradeoffs is the mix of your active versus passive investments.

What are active and passive investments?

As the name suggests, active investing is where a person or group of people is actively managing your money. They conduct deep research into the value of individual investments and take advantage of fluctuations in the market to buy low and sell high. These investments typically target returns in excess of a specific benchmark index.

Passive investing on the other hand is one where there are limited transactions. You typically buy an index fund which aims to replicate the performance of a well-known index such as the S&P 500 for stocks. There’s very little research or analysis done by the fund management as the investment’s aim is to replicate the index with limited buying and selling. As most asset classes increase in value over the long term, passive investing aims at riding that growth with the lowest additional costs.

What are the pros and cons of each type of investing?

Like anything else, active and passive investing have their pros and cons. Because they are two different sides of the same coin with respect to investing styles, their pros and cons are typically the opposite of each other so I’m just going to focus on each of the styles' pros.

Active investing pros:

• Professionally managed with significant resources to do deep research and identify pricing anomalies
• Can take advantage of volatility in pricing that creates the opportunity to buy low and sell high
• Some opportunity to manage taxes by offsetting tax gains with tax losses
• Ability to reduce over concentration in cases where a capitalization-weighted index is dominated by a small number of investments

Passive investing pros:

• Low fees which translate directly into better net returns as investment leakage through transaction costs are minimized
• Lower impact on taxes. Fewer transactions mean less likelihood for short- and long-term capital gains to be levied
• Greater transparency in what you own. Passive investments aim at replicating an index so you know what you get when you invest in one of them

Which style is better?

Unfortunately, there is no simple answer to this question.

One often sees quotes showing that individual investors underperform the market, such as: “For the 20 years ending December 31, 2019, the S&P 500 Index averaged 6.06% per year. The average equity fund investor earned a market return of only 4.25%.” (Dalbar study quoted in The Balance). Such results have lead great investors to advocate for passive investing. For example, Warren Buffett has said that “In my view, for most people, the best thing to do is owning the S&P 500 index fund,” (Warren Buffett quoted in Nerdwallet). This would definitely support the view that passive investments are key for the majority of people’s investments.

I certainly agree with Mr. Buffett and believe that owning such an index fund is a core part of any portfolio. However, I also believe that active investments can be an important part of a successful portfolio, especially for asset classes which are smaller and have less publicly available information. The key decision factor is what is the correct mix between these two styles. The way I approach determining this mix requires some explanation so I will focus my next post on providing more details on when and where active investments should be in one’s portfolio.

This completes today’s post on active versus passive investing. For those of you who have read some of my posts, you will know that I end each of them with practical steps you can start taking from that post. However, today’s post was about just providing basic information about active and passive investing. My next post will provide more details on how best to incorporate each within your portfolio and will include practical steps to determine the appropriate mix of the two styles.

Thank you again for joining me on my journey to build financial literacy for young adults and their families. If you are interested in reading more of my posts, please access my author page (https://shopping-feedback.today/authors/sudhir-sahay) where you can see all the posts I’ve published. If you have any questions on today’s post of if there are any topics you’re interested in my broaching in future posts, please let me know. I can be reached at [email protected].